Causal links between hot money and investment markets: evidence from small-scale economy

Abstract

Hot money is generally associated with economic and financial turmoil in emerging economies. In this backdrop, a number of studies document the causal links between hot money and financial markets. Accordingly, the study examines the causal relationship among hot money, equities, and real estate assets in the small-scale economy of Pakistan. For this purpose, we employ various time series techniques such as the JJ Co-integration test, Granger causality tests, Impulse Response Functions (IRF), and Variance Decomposition Analysis (VDC). The findings validate the long-term association between speculative funds and underlying investment markets. The results uncover unidirectional causality from investment markets to hot money in Pakistan. However, the lack of a bi-directional relationship among the underlying variables indicates that hot money is not a major driver of soaring prices in equities and real estate assets. Alternatively, developing the underlying markets attracts speculative cash inflows into the economy. The findings of the study highlight some useful implications for investors and regulators. For instance, the study's findings present valuable insights for international investors seeking diversification opportunities in small-scale economies such as Pakistan. Also, the regulators in the underlying economy can utilize the study findings to formulate an optimal model to manage international capital flows.